The Cost of Capital for Foreign Investments

1
The Cost of Capital for Foreign Investments

• P.V. Viswanath
• International Corporate Finance

2
Learning Objectives

• How Capital Budgeting can differ in an
  international context
• What is the traditional notion of Cost of
  Capital?
• How do we estimate the cost of equity and the
  cost of debt in a domestic context?
• What is the relevance of who owns the company?
• How do we use proxy companies in estimating cost
  of equity?
• What is the relevance of country risk?
• How do we estimate country risk?

3
Capital Budgeting for Foreign Investments

• Capital Budgeting in an international environment
  raises issues that are not present in a domestic
  setup.
• Cashflows depend on capital structure because of
  cheap loans from foreign governments. This makes
  the cost of capital to the corporation different
  from the opportunity cost of capital for
  shareholders.
• There are exchange-rate risks, country risks,
  multiple tiers of taxation, and sometimes
  restrictions on repatriating income.
• In principle many of these issues can be resolved
  using an adjusted present value approach, where
  the project is valued as a stand-alone all equity
  project and impact of the the different financing
  frictions are added to this base value.
• However, in practice, most firms use a NPV/IRR
  approach. Hence we shall focus on computing the
  right cost of capital to evaluate projects.

4
The cost of capital

• In what follows, we will assume that the
  subsidiary or project cashflows have been
  restated in dollars. Hence the issue is coming
  up with a discount rate that is appropriate for
  dollar flows.
• One implication of this is that the correct
  riskfree rate to use is a Treasury rate.
• In principle, the cost of capital used should be
  a forward-looking rate. However, in practice,
  the components of the cost of capital are often
  estimated using historical data.
• While this is unavoidable, historical estimates
  should be used with care.

5
The WACC

• If the financial structure and risk of a project
  is the same as that of the entire firm, then the
  appropriate discount rate is the Weighted Average
  Cost of Capital WACC ke(1-d) id(1-t)d
• where
• d the firms debt-to-assets ratio (debt ratio)
• id before-tax cost of debt
• ke cost of equity
• t marginal tax rate of the firm
• In using the WACC for project selection, the
  value of d used must be the target debt ratio.
• If the risk of a project is different, then it
  should be evaluated using its own beta, and its
  own target debt-to-assets ratio, etc.

6
The cost of equity

• According to the CAPM, the required rate of
  return on an asset is given as

• Rf risk-free rate
• bi beta of asset i, a measure of its
  non-diversifiable risk.
• In principle, the CAPM applies to all assets, but
  in practice
• It is used to estimate the cost of equity
• It is rarely used to estimate the cost of debt
  because it is very difficult to estimate a beta
  for debt securities.

7
The cost of debt

• In practice, the yield-to-maturity is used
  instead of the required rate of return, for debt
  securities.
• Where the bond is not traded, and hence no
  implied yield-to-maturity can be computed,
  firm-specific variables, such as
  interest-coverage ratios are used to generate
  synthetic bond ratings.
• Historical relationships between bond-ratings and
  bond spreads over Treasuries are then used to
  come to an estimate of the bond's
  yield-to-maturity.

8
Cost of Equity for foreign projects

• If the firm's equity investors hold a diversified
  US portfolio, then the beta should be computed
  for the new project with respect to the US equity
  index (market portfolio) and the required rate of
  return can be computed using the CAPM, even
  though the project may be a foreign project.
• If the "US" firm's investors are really holding a
  globally diversified portfolio, or if they are
  not restricted to the US (and hence, once again,
  they hold globally diversified portfolios), then
  it makes sense to compute an equity cost of
  capital for them by using the global CAPM, i.e.
  computing the beta for the new project using the
  global "market" portfolio (and a global risk
  premium).

9
Cost of Equity for foreign projects

• However, in practice,
• US investors may not be globally diversified, and
• It may be easier to obtain US data than global
  data
• Consequently, US MNEs often evaluate projects
  from the viewpoint of a US investor, who is not
  diversified internationally.
• Furthermore, a recent study (2004) showed that a
  cost of capital estimated using a domestic CAPM
  model is insignificantly different from a cost of
  capital computed using global risk factors.

10
Issues in estimating cost of capital for foreign
projects

• In order to estimate a beta for the foreign
  subsidiary, a history of returns is required.
  Often this is not available. Hence, a proxy may
  have to be used, for which such information is
  available.
• Should corporate proxies be local companies or US
  companies?
• The beta is the estimated slope coefficient from
  a regression of the stock returns against a base
  portfolio, which is the global market portfolio,
  according to the CAPM. However, this assumes
  that markets are integrated.
• In practice, is the relevant base portfolio
  against which proxy betas are to be estimated,
  the US market portfolio, the local portfolio, or
  the world market portfolio?
• Should the market risk premium be based on the US
  market or the local market or the world market?
• How should country risk be incorporated in the
  cost of capital?

11
Using Proxy Companies to estimate beta

• Since we want a proxy as similar as possible to
  the project in question, it makes sense that we
  use a local company.
• The return on an MNCs local operations will
  depend on the evolution of the local economy.
• Using a US proxy is likely to produce an upward
  biased estimate for the beta.
• This can be seen by looking at the definition of
  the foreign market beta with respect to the US
  market
• Foreign companies are likely to have lower
  correlation with the US market than US companies.

12
Using Proxy Companies to estimate beta

• If foreign proxies in the same industry are not
  available (say because of data issues), then a
  proxy industry in the local market can be used,
  whose beta is expected to be similar to the beta
  of the projects US industry.
• Alternatively, compute the beta for a proxy US
  industry and multiply it by the unlevered beta of
  the foreign country relative to the US. This
  will be valid, if
• The US beta for the industry is the same as that
  of that industry in the foreign market as well,
  and
• The only correlation, with the US market, of a
  foreign company in the projects industry is
  through its correlation with the local market and
  the local markets correlation with the US market.

13
The Relevant Market Risk Premium

• Although, in principle, it may be appropriate to
  use a global market portfolio, in practice, we
  use the US market portfolio, for several reasons
• the small amount of international diversification
  of US investor portfolios
• since US projects are evaluated using a US base
  portfolio, use of a US base portfolio means that
  foreign projects can be easily compared to a US
  project.
• Correspondingly, a market risk premium based on
  the US market is used, as well.
• US markets have much more historical data
  available, and it is a lot easier to estimate
  forward-looking risk premiums for the US market.
  However, the US market risk premium is often
  adjusted to take country risk premiums into
  account.

14
Country Risk Premiums

• The previous approaches that use US base
  portfolios and/or US proxies effectively ignore
  country risk, assuming that it is diversifiable.
  However, this may not be the case. In fact, with
  globalization, cross-market correlations have
  increased, leading to less diversifiability for
  country risk.
• Furthermore, it may not be enough to look at the
  beta alone of a foreign project's beta, because
  this only deals with contribution to volatility.
• Skewness or catastrophic risk may be significant
  in the case of emerging markets. The impact of a
  project on the negative skewness of the
  equityholder's portfolio could be significant and
  should be taken into account.

15
Country Risk Premiums

• For example, India's beta could be negative, but
  it would not be appropriate to discount Indian
  projects at less than the US risk-free rate.
• If investors do not like negative skewness (i.e.
  the likelihood of catastrophic negative returns),
  we should augment the CAPM with a skewness term.
• An alternative would be to estimate a country
  risk premium based on the riskiness of the
  country relative to a maturity market like the
  US, and to incorporate this into the cost of
  equity of the project.

16
Estimating Country Premiums

• Country Premiums may be estimated by looking at
  the rating assigned to a countrys
  dollar-denominated sovereign debt.
• One can then look at the spread over US
  Treasuries or a long-term eurodollar rate for
  countries with such ratings (sovereign risk
  premium). This spread would be a measure of the
  country risk premium.
• One could also look at the spread for US firms
  debt with comparable ratings.
• Optionally, one might then adjust this spread by
  the ratio of the standard deviation of equity
  returns in that country to the standard deviation
  of bond returns to convert a bond premium to an
  equity premium.

17
Using the Country Premium

• The country risk premium that is obtained can
  then be used in two ways
• One, it could be added to the cost of equity of
  the project. This assumes that the country risk
  premium applies fully to all projects in that
  country
• Two, one could assume that the exposure of a
  project to the country risk is proportional to
  its beta. In this case, one would add the
  country risk premium to the US market risk
  premium to get an overall risk premium. This
  would then be multiplied by the beta as before to
  obtain the project-specific risk premium.

18
Using the Country Risk Premium

• Finally, one could take the US market risk
  premium and multiply it by the ratio of the
  volatility of stock returns in the foreign
  country to the volatility of stock returns in the
  US.
• This is the country-risk adjusted market risk
  premium.
• As before, then, this market risk premium would
  be multiplied by the beta of the project to get
  the project-specific risk premium.

19
Adjusting for Country Risk

• Suppose the market risk premium in US markets is
  5.5
• The yield on US 10 year treasuries is 5
• The yield on German government bonds is 6
• The world nominal risk-free rate (computed as the
  lowest risk-free rate that can be obtained
  globally, for borrowing in dollars or otherwise
  adjusted for exchange rate risk) is also assumed
  to be 5.

20
Adjusting for Country Risk

• Project beta with respect to US market is 1.0
• Project beta with respect to an international
  equity index is 1.1
• The beta of the German market with respect to the
  US market portfolio is 1.2.
• The volatility of returns (std devn) on a
  broad-based US market index is 25 per year.
• The volatility of returns on a broad-based German
  index is 35 per year.
• The volatility of returns on a broad-based world
  index is 30 (returns measured in dollars)

21
Adjusting for Country Risk

• Reqd. ROR US Riskfree rate bi(Market Risk
  Premium)
• If the investors in the project are investors who
  hold domestic (US) diversified portfolios, then
  we use US quantities.  Suppose country risk is
  diversifiable or can otherwise be ignored
• Reqd ROR 5 1 (5.5) 10.5, and country risk
  premium is set at zero.
• If the investors are internationally diversified,
  and country risk can be ignored,
• Reqd ROR 5 1.1 (5.5) 11.05, and country
  risk premium is set at zero.
• If we take a weighted average of the two rates
  (in this example, we use 65-35 weights), we get
  0.65(10.5) (0. 35)(11.05) 10.6925

22
Adjusting for Country Risk

• If we believe that country risk is not
  diversifiable and/or is not otherwise captured in
  the beta computation or that it captures other
  kinds of risk that go beyond variability risk, we
  need to adjust for country risk.
• Add sovereign risk premium to the required rate
  of return(If we are worrying about country risk
  premiums, were probably discounting the
  existence of a single international asset pricing
  model, since it implies an integrated world.)
• In this case, the risk-free rate in Germany is
  8, which is greater than the US 10 year treasury
  yield of 5 by 100 bp.
• This gives us a cost of equity capital of
• 5 (6 - 5) 1(5.5) 11.5

23
Adjusting for Country Risk

• If we assume that the country risk premium is
  shared by the project only to the extent that it
  moves with the market, then wed get
• Required ROR 5 1(5.5 1) 11.5 (in this
  case, the rate doesnt change from the approach
  above, since the beta is 1).
• If we say that the country risk premium is shared
  by the project only to the extent that it moves
  with its local market
• Reqd ROR 5 1 (5.5) (1.2)(1) 14.1, where
  the 1.2 is the beta of the German market w.r.t.
  the US market portfolio.
• Amplifying CAPM beta by volatility ratio
• Amplified beta 1x(35/30)
• Hence the required rate of return is 5
  1(35/30)(5.5) 11.42

24
Computing cost of debt on foreign-currency loans

• Suppose Alpha S.A., a French subsidiary of a US
  firm borrows 10m. for 1 year at an interest rate
  of 7. If the current rate is 0.87/, this
  would be a 8.7m. loan.
• If the end-of-year rate is expected to be
  0.85/, the dollar cost of the loan is only
  4.54, since (10.7)(0.85)/8.7 1.0454.
• In general, the dollar cost of a foreign currency
  loan with an interest rate of rL and a
  depreciation of the home currency of c per year
  is given by rL(1 c) c.
• If the loan is taken by a foreign subsidiary and
  the interest can be deducted for tax purposes,
  where the tax rate is ta, then the effective
  dollar rate is r rL(1c)(1-ta) c.

25
The Cost of Debt Capital

• In general, the effective dollar interest rate
  is, r, where
• c is the annual rate of appreciation of the local
  currency
• rL is the coupon rate of the loan
• ta is the affiliates marginal tax rate

• However, the solution to this general problem is
  the same as the solution to the single period
  problem.
• Finally, we put the cost of debt and the cost of
  equity together to get the WACC.

26
Problem Cost of debt capital

• IBM is considering having its German affiliate
  issue a 10-year 100m. bond denominated in euros
  and priced to yield 7.5. Alternatively, IBMs
  German unit can issue a dollar-denominated bond
  of the same size and maturity and carrying an
  interest rate of 6.7.
• If the euro is forecast to depreciate by 1.7
  annually, what is the expected dollar cost of the
  euro-denominated bond? How does this compare to
  the cost of the dollar bond?

27
Problem Cost of debt capital

• The pre-tax cost of borrowing in euros at a
  interest rate of rL, if the euro is expected to
  depreciate against the dollar at an annual rate
  of c, is rL(1 c) c. There is a
  depreciation penalty applied to the interest
  (first term) and to the principal (second term).
• In this case, we get an expected cost of
  borrowing euros of 7.5(1-0.017)-1.7 or 5.67.
  This is below the 6.7 cost of borrowing s.
• If the German unit is taxed at ta, the ta, is r
  rL(1c)(1-ta) c. Thus, if ta 35, r
  7.5(1-0.017)(1-0.35) - 0.017, or 4.78.

28
Differentials in Cost of Funds for foreign
projects

• What if funds are available to finance foreign
  projects at below-market costs?
• Suppose a foreign subsidiary requires I of new
  financing for a project as follows P from the
  parent, Ef from the subsidiarys retained
  earnings, Df from foreign debt.
• Suppose the cost of retained earnings for the
  subsidiary is ks versus the general cost of
  equity for the parent, ke, and that the cost of
  debt financing after-tax for the subsidiary is if
  versus the after-tax cost of debt for the parent
  of id(1-t).

29
Cost of foreign project

• Then the total cost of financing the project in
  dollars is
• IkI Iko - Ef (ke - ks) - Dfid(1-t) - if
• Simplifying, we find that the WACC for the new
  project, kI equals
• kI ko - a (ke - ks) - bid(1-t) - if
• whereko cost of capital of the parentks cost
  of retained earnings for the subsidiaryif the
  after-tax cost of foreign debta Ef/Ib Df/I